ETFs to help tackle climate change

Launched in 2020, Paris-aligned benchmarks (PABs) are indices made up of companies that are more aligned with the Paris Agreement. This legally binding international treaty seeks to limit the rise in global temperatures to well below 2°C, preferably below 1.5°C, compared to pre-industrial levels.

PABs require a 50% reduction in greenhouse gases compared to the respective index and a 7% year-on-year reduction of relative emissions. This is accompanied with exclusions on companies associated with controversial weapons, coal, oil, natural gas, carbon intense energy producers and violators of predefined societal norms.

PABs enable the redirection of money to the low-carbon section of the market. The underlying securities are selected, weighted, or excluded so that the ones which already more actively contribute to the objectives of the Paris Agreement are given precedence.

What is the Climate Transition Benchmark (CTB)?

When introducing PABs, the EU also established the Climate Transition Benchmark (CTB).

A CTB is a benchmark where the underlying assets are selected, weighted, or excluded in such a way that the resulting benchmark portfolio offers a ‘decarbonisation trajectory’ in line with the objectives of the Paris Agreement.

While PAB requires a 50% reduction in greenhouse gas emissions relative to the index, CTB recommends a minimum 30% reduction. CTB also requires companies associated with controversial weapons or violators of predefined societal norms to be excluded.

The EU intends for CTBs to be used as tools to accompany the transition to a low-carbon economy. Whereas PABs are for investors who want to be at the forefront of the transition.

How do ETFs track these benchmarks?

ETFs will usually buy the basket of investments that represents these benchmarks. This generally includes buying all constituents of the index and in the same proportion to ensure it meets the goal of reducing carbon emissions over time.

These ETFs offer investors access to a ready-made investment portfolio run by a professional fund manager. Using an ETF wrapper provides access to these diversified portfolios for a much lower cost than purchasing the individual investments.

This article isn’t personal advice. If you’re not sure if an investment is right for you, ask for financial advice. Investments rise and fall in value, so you could get back less than you invest.

How is Paris alignment achieved?

These benchmarks increase transparency with respect to the impacts of investments. The stringent emission reduction expectations mean that investors can be assured their money is contributing to the net-zero transition.

The right to use the EU PAB and CTB labels on investment products is strictly controlled. Any failure to reach annual decarbonisation goals must be explicitly justified, along with explanations of the planned corrective measures. Failure to reach the set targets for two consecutive years, or failure to reach the targets three times within ten years, will result in loss of the right to use the label.

These high expectations leave no room for greenwashing.

What challenges are climate transition benchmarks facing?

The success of these benchmarks relies on the availability and accuracy of companies’ emissions data.

Businesses have three scopes of emissions.

Scope 1 emissions are those that are owned or controlled by the company. Scope 2 are indirect emissions, like electricity usage. Scope 3 are all other emissions that are not produced by the company itself, that it is indirectly responsible for. Scope 3 accounts for 75% of overall emissions on average.

Currently, only the energy and mining sector are required to disclose their scope 3 emissions to make it into PABs or CTBs. Companies in other sectors only need to disclose scope 1 and 2 emissions.

If around three quarters of emissions are unaccounted for across these sectors, this poses a significant question over the real-world impact of these benchmarks.

Collection and measurement of scope 3 emissions presents a key challenge to companies trying to disclose them. Access to relevant data, understanding of the methodologies and internal expertise are often required.

Yet the constituents of these indices are companies with often ambitious emission reduction targets. While they might not include all of their emissions, their intention and mission is clear.

From the end of 2024, the EU is requiring scope 3 inclusion for PABs and CTB constituents. This regulatory tailwind will support data availability for, and validation of, these benchmarks.

How could they fit into a portfolio?

PAB and CTB ETFs track these benchmarks and offer a tool to support climate-focused investment strategies. And as well as aiming to optimise ESG opportunities, these products offer investors a hedge against a range of climate-transition risks.

By having exposure to the low-carbon economy, climate-related market risks can be minimised. In particular, changes in supply and demand for goods and services, like the shift from carbon intensive vehicles to electric vehicles.

PAB or CTB ETFs are likely to be aligned to upcoming green regulation, minimising policy and legal risk. There should also be reduced reputational risk from emissions scandals and targeted climate activism too.

When it comes to building the portfolio itself, this four step approach is an option for most investors. We think an investment in this type of ETF should usually only form a small part of a well-diversified portfolio.

Climate transition benchmarks could be a satellite option for investors looking to add more ESG-thematic investments to their portfolio. If you want to learn more about responsible investing, explore the responsible investment section of our website. It includes a variety of information to help you get started investing responsibly, from helpful tips and tricks to fund ideas.

Please note, investing in one sector adds risk if the sector falls out of favour.

READ MORE ON RESPONSIBLE INVESTING

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Our ETF research is for investors who understand the risks of investing and that investing in ETF's isn't right for everyone. Investors should only invest if the ETF's objectives are aligned with their own, and there's a specific need for the type of investment being made. Investors should understand the specific risks of an ETF before they invest, and make sure any new investment forms part of a diversified portfolio.